Activity-based Costing (ABC) vs Traditional Costing

See Also:
Activity Based Costing
Standard Costing System
Cost Driver
Value Chain
Implementing Activity Based Costing
Absorption vs Variable Costing
Activity Based Management
Process Costing
Job Costing

Activity Based Costing Costing vs Traditional Costing

In the field of accounting, activity-based costing and traditional costing are two different methods for allocating indirect (overhead) costs to products.

Both methods estimate overhead costs related to production and then assign these costs to products based on a cost-driver rate. The differences are in the accuracy and complexity of the two methods. Traditional costing is more simplistic and less accurate than ABC, and typically assigns overhead costs to products based on an arbitrary average rate. ABC is more complex and more accurate than traditional costing. This method first assigns indirect costs to activities and then assigns the costs to products based on the products’ usage of the activities.

Traditional Costing Method

Traditional costing systems apply indirect costs to products based on a predetermined overhead rate. Unlike ABC, traditional costing systems treat overhead costs as a single pool of indirect costs. Traditional costing is optimal when indirect costs are low compared to direct costs. There are several steps in the traditional costing process, including the following:

1. Identify indirect costs.

2. Estimate indirect costs for the appropriate period (month, quarter, year).

3. Choose a cost-driver with a causal link to the cost (labor hours, machine hours).

4. Estimate an amount for the cost-driver for the appropriate period (labor hours per quarter, etc.).

5. Compute the predetermined overhead rate (see below).

6. Apply overhead to products using the predetermined overhead rate.

Predetermined Overhead Rate Calculation

Use the following formula to calculate predetermined overhead rate:

Predetermined Overhead Rate = Estimated Overhead Costs / Estimated Cost-Driver Amount

For example:

$30/labor hr = $360,000 indirect costs / 12,000 hours of direct labor

Activity-Based Costing Benefits

Activity based costing systems are more accurate than traditional costing systems. This is because they provide a more precise breakdown of indirect costs. However, ABC systems are more complex and more costly to implement. The leap from traditional costing to activity based costing is difficult.

Traditional Costing Advantages and Disadvantages

Traditional costing systems are simpler and easier to implement than ABC systems. However, traditional costing systems are not as accurate as ABC systems. Traditional costing systems can also result in significant under-costing and over-costing.

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activity based costing vs traditional costing

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17 Responses to Activity-based Costing (ABC) vs Traditional Costing

  1. Bill Clark October 10, 2013 at 10:12 am #

    Jim, Allow me to suggest that both traditional accounting and activity-based costing systems, or some other managerial accounting system/tool, have their “place and time.” Given a company’s specific situation, each accounting system serves a purpose better than the other, and each comes with its own set of implementation difficulties, advantages and disadvantages. Should one decide to use a managerial accounting system, it will require two sets of books that ultimately must be reconciled and use the resources necessary to maintain and update those books. Simply put, ABC is not the answer for all companies; but sometime, it is.

    First, let’s be clear, traditional accounting is not an option. It is a requirement imposed by GAAP, investors, financial reporting, and a myriad of other accounting rules and regulations. It is not a choice! Still, it may be the only accounting tool a company needs. It can be just as accurate as ABC if product complexity and variety are limited. A company weighted toward manufacturing and labor, with little overhead, already knows the cost and profit connected with its offerings. It doesn’t need ABC to tell them what it knows, and any ABC implementation would be a waste of time and resources.

    Product complexity and variety should lead a company to ABC. Because it uses consumption and/or transactional drivers to assign cost to activities, it is a more accurate reflection of product and customer profitability. In this instance, implementing ABC is a distinct competitive advantage as it leads to better decision-making and a strong link between strategy and operations. Accuracy, in any accounting tool, is a function of the software, the implementation plan and chosen drivers. Under the right ciscumstances, ABC can be a huge win.

    As you’ve noted, it is difficult converting from ABC to traditional accounting. In my experience, success depends on several key factors:
    •Change management,
    •Cultural acceptance, and
    •Executive management support.
    One could write an entire book, as some have done, on how to successfully navigate these hazards when implementing ABC.

    Over my thirty years in the financial industry, I’ve overseen implementations of both traditional and managerial (ABC) accounting systems. Each has served a function, each has come with its own unique set of challenges, and each has proven successful – when implemented correctly.

    • dela November 8, 2015 at 9:40 am #

      If I may ask, though ABC system have created more excitement in academia, they are still second to traditional system. Why??

      • syed May 19, 2017 at 1:04 am #

        because it is very time consuming and costly a benefits is that it provides more accurate results.

    • K December 21, 2016 at 10:36 am #

      Hello, mr. Clark! How are you doing? I have a question concerning Traditional And ABC costing and if it is possible could you please help me?

  2. ting November 16, 2014 at 1:19 am #

    can i ask the usage of inaccurate overhead allocation basis will affect the truth and fairness of a company’s financial statements.” Discuss.

    • Komal October 9, 2016 at 1:12 pm #

      In my opinion it will not. Cost accounting is internal accounting used by management for internal control over cost and output. It is mainly used to understand and correct production processes. It has no reflection in books of accounts.

  3. Alex Ondieki October 16, 2016 at 1:33 pm #

    Much of this information that I have gone through here is quite important. I have compared between traditional method and activity-based costing method and I can say that its of much benefit to use action-based costing method. What I do not understand is why GAAP considers the use of Traditional method over action-based method

    • Dipesh October 9, 2017 at 11:56 pm #

      Consider someone has produced 3 different products by incurring a total cost of $100. For accounting and reporting perspective, cost incurred will remain $100. Over-all profitability and health of Balance Sheet are all most financial investors are interested in.

      However, ABC helps in allocating the same $100 to different products. Such allocation helps in Strategic decision making, such as Pricing.

  4. Richy November 14, 2016 at 6:42 am #

    in my side view, I agree with komal that it will not. since cost accounting it is used internally to deal with Various matters such as to support in decision making, provision of transactions information and etc.

  5. Ronald konzani May 15, 2017 at 2:18 am #

    To state that all traditional costing systems are irrelevant in today’s manufacturing environment is an over-simplification, but as research shows most manufacturing companies still use machine hour or direct labour burden rates as the sole basis to allocate overheads to products when calculating products costs. However, it has been said the relationship between a product and the overheads it causes can no longer be expressed in simple terms as single overhead burden rate.

    You are required to:

    To identify and discuss four factors that support the assertions that the relationship between a product and the overheads it causes can no longer be expressed in simple terms as single burden rate.

  6. ckuku October 18, 2017 at 6:26 am #

    as for me am not aware.

  7. Que dric Pieters November 12, 2017 at 5:34 pm #

    Is strategic cost analysis the same as ABC costin??

    • madonna April 5, 2018 at 6:54 pm #

      look everyone, the activity based costing system is clearly the superior of the two. given my 88 years of experience in the biology field, I would know the correct answers to your questions. abc for the win. have a nice day!

  8. guong tron day da May 29, 2018 at 9:32 am #

    Precisely ᴡhɑt Ӏ was ⅼooking for, regarԁѕ for putting ᥙp.

  9. Hannah Lahham January 4, 2019 at 10:12 am #

    What may cause ABC to give different results to traditional costing?

    • John lotisia March 6, 2019 at 10:20 am #

      ABC use more cost drivers based on their activities while traditional cost system arbitrary average rate

  10. John lotisia March 6, 2019 at 10:22 am #

    ABC use more cost drivers based on their activities while traditional cost system arbitrary average rate

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